Financial Markets and Institutions (2-downloads)

7. Collateral is a prevalent feature of debt contracts for both 

households and businesses.

Collateral is property that is pledged to a

lender to guarantee payment in the event that the borrower is unable to make

debt payments. Collateralized debt (also known as secured debt to contrast

it with unsecured debt, such as credit card debt, which is not collateral-

ized) is the predominant form of household debt and is widely used in busi-

ness borrowing as well. The majority of household debt in the United States

consists of collateralized loans: Your automobile is collateral for your auto

loan, and your house is collateral for your mortgage. Commercial and farm

mortgages, for which property is pledged as collateral, make up one-

quarter of borrowing by nonfinancial businesses; corporate bonds and other

bank loans also often involve pledges of collateral. Why is collateral such

an important feature of debt contracts?